Many people are already working at the type of companies Buffett is searching for. They have an intimate knowledge of the business, management and prospects for the company. As insiders, they may have a better understanding of their own company than the Wall Street analysts that cover it.
Buffett also says that you should not try to predict general business fluctuations or the direction of the stock market. In other words, you should not be concerned with what someone thinks the market might do and instead focus on what the “company” will do. After all, there isn’t anyone who can accurately predict markets. As the saying goes: “even a broken clock is right twice a day.”
Here are some of his best thoughts:
No Need to Forecast the Market
Buffett describes the market in the late 1950s as exuberant, as “investors” believe they can make easy money in the market. He does not know how long these speculators will be able to add to their numbers and keep prices moving higher, but he stresses that he does not attempt to forecast the market.
Illiquid Investments Not A Problem
Buffett notes that during bull markets, he would be satisfied just to match the performance of the general market. However, during bear markets, he believes it is likely his fund will outperform. This is because he owns a lot of securities that don’t move with the general market, including tiny companies that are owned by few people and don’t trade often.
Willing to Sell Cheap To Buy Even Cheaper
Buffett describes one particular large investment his fund sold out of in the previous year. Buffett purchased a bank stock for around $50/share that he believed was worth $125/share. (It had earnings of $10/share.) Because he was so confident in his estimates, he wanted the stock price to remain low so that he could continue to purchase shares at a low price. He ended up selling out at $80, which is still undervalued in his estimation, in order to take advantage of an even more compelling situation.
Willingness To Bet Big
Buffett was willing to invest 35% of the partnership’s assets in the new situation!
Influence Counts
Buffett did not consider this investment more undervalued than some of his other securities. However, becoming the largest shareholder of this stock, which comprised of investments worth substantially more than the stock price, has benefits that he hoped would help him realize large profits in the following year.
Add Value Or Don’t Do It
Buffett’s objective is to achieve long-term returns superior to those of the Dow Jones Industrial Average. If he is unable to do that, he notes that there is no reason for the partnership to exist. Capital would be misallocated.
Long-term Focus
What happens in any one year is irrelevant. In fact, during bull markets, Buffett expects his returns to be lower than those of the market. What’s important is whether the partnership can outperform over several years, cumulatively. Buffett is “much more geared towards five-year performance, preferably with tests or relative results in both strong and weak markets.”
Asset Values Are Sometimes Ignored
Buffett discusses a stock in which he invested 35% of the partner’s funds. The company, Sanborn Maps, had lost a lot of earnings power in recent years. However, the company had stockpiled cash during its good years, and therefore had a portfolio of investments adding up to way more than the stock price. The company was on sale for just 70% of its investments (in the form of blue-chip stocks), with the map business thrown in for free!
Patience Is Key
Buffett has begun open market transactions of a “potentially major commitment”. As such, he hopes the stock does not increase in price for the next year, in order that he may accumulate more shares. A stagnant stock in which the partnership holds a large position would most assuredly hurt the partnership’s short-term performance, but that is irrelevant in the long term.
Establishing the benchmark in advance
After the fact, a fund’s performance can always be made to look good by comparing it to something that was worse. For this reason, Buffett prefers to set the benchmark ahead of time. Though noting that it has its flaws, Buffett has chosen the Dow Jones Industrial Average as a benchmark because it is widely known, has a long and continuous history, and reflects the experience of investors with the market. He notes that while it is an unmanaged index of 30 leading stocks, it still manages to beat most mutual funds.
Use a margin of safety
Most of the fund’s assets are invested in securities representing companies over which Buffett has no control or influence. This has been the largest category of the fund’s investments, and “more money has been made here than in either of the other categories”. At the time of purchase, it is difficult to determine when or why these will appreciate in price. Yet, because of the lack of glamour and because there is nothing pending that would create favorable price action, these securities are available at very cheap prices.
Borrowing for investing is unnecessary
Buffett’s preference is not to owe any money to his fund. However, he does note that situations he calls “work-outs” are particularly safe, and at times he does borrow against the portion of his portfolio invested in “work-outs”. These are situations where Buffett invests in mergers, liquidations or spin-offs, where the financial result can be calculated on a specific timetable, albeit with some risks. At any given time, he is invested in ten to fifteen such situations, and the results yield between ten and twenty percent (before borrowing).
Conservative investing is not what they say it is
A few years ago, Buffett writes in 1962, the purchase of municipal bonds was considered conservative. Today (1962), the purchase of blue chip stocks is considered conservative. Buffett disagrees: “There is nothing at all conservative, in my opinion, about speculating to just how high a multiplier a greedy and capricious public will put on earnings.” Even though Buffett’s portfolio is unconventional, he believes it to be conservative. He argues that the best test of conservatism in a portfolio is its performance when general market prices decline.
Judge Performance Over The Long Term
Buffett prefers to measure the performance of a fund over at least five years of returns relative to a benchmark specified in advance. At an absolute minimum, Buffett requires at least three years to be considered before giving any credence to a fund’s returns.
Manager And Investor Interests Should Be Aligned
Buffett makes clear to his investors that he, his wife and his children have, and will continue to have, substantially all of their net worth invested in this partnership.
Management Matters
Having invested enough money to acquire control of a company called Dempster Mill at a discount to net working capital, Buffett attempts conversations with management to get the company on the right track. Six months later, he notices that costs are still high, so he decides to hire his own manager, and compensates him based on his meeting specific cost-cutting goals. This manager was able to cut the company’s break-even point in half. As a result, this company generated substantial returns for investors.
Don’t Count On The Business Doing Well
In the business described in the previous paragraph, strong improvement in the business’ operations resulted in considerable returns. But Buffett makes the point that the fact that the business did well was just a bonus. The price paid for that business was so low that even if the business did not improve, Buffett would likely still have made money.
Low Risk And High Reward Are The Way To Go
Buffett describes an arbitrage situation in which he invested that generated a 20%+ annualized return with little risk. When Union Oil announced it was buying Texas National Petroleum, Buffett noted that there were no anti-trust issues and the transaction was negotiated by controlling shareholders of the target. As such, he appraised the risk at virtually nil.
Don’t Invest Based On Rumours
Buffett had heard about the above transaction before it was even announced. Had he invested then, he would have made much more money on this deal. However, he implies that rumors are often wrong and that investing on this basis is “somebody else’s business, not mine”.
Stick With It
Buffett describes a situation where he purchased stock in a company trading at a sharp discount to its net current assets that did not see gains for five years! Eventually, Buffett accumulated so many shares that he was in a control situation, and was able to effect change from the inside. This was not his intent from the beginning, but the growth of his fund allowed him to continue to purchase more and more of the undervalued shares, and he did so despite the fact that the company performed poorly for five years in a row.
Large Funds Can’t Keep Up
When comparing performance to some of the country’s largest funds, Buffett notes that the returns of these funds mostly lag the market. Buffett expects large funds such as these to mostly generate the same returns as that of the market, as all they do is buy the largest companies. It bewilders him that they take credit for their strong returns when the market goes up, for they don’t control the market’s performance.
Group Think
In this letter, Buffett delves into some possible reasons why the top investment management firms cannot beat the passive Dow Jones Industrial Average even as Buffett trounces it. Buffett doesn’t believe it to be a lack of integrity or of intelligence at the top firms. He attributes their under-performance to, among other things, group decisions. His opinion is that “…it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions.”
Relative Valuation Can Still Be Pricey
Buffett describes a growing portion of his portfolio where companies are not cheap by “private owner” standards, but rather on a relative basis compared to similar companies. For example, he may buy a company at a P/E of 12 while a similar company of lower quality sells for a P/E of 20. While he notes that this section of his portfolio is showing promise, he does worry about situations where the latter company gets revalued to a P/E of 10. Buffett does hint at this point that he is implementing a technique to reduce this risk.
Don’t Let Taxes Stop You
Nobody likes taxes, but Buffett argues that more investment mistakes are committed in the name of tax considerations than from any other cause. Buffett quotes a friend who argues that a majority of life’s errors are caused by forgetting what one is really trying to do. Paying the least amount of taxes is not the investor’s goal; instead, the investor is trying to come away with the largest after-tax return. These are often not the same thing.
You Can Be Too Big OR Too Small
This is the year Buffett closes the partnership to new members. He believes the size of the fund (at $46 million at the end of 1965) will now become a disadvantage in generating returns superior to those of the Dow. But he also believes the fund was large enough to take advantage of opportunities he couldn’t have otherwise (i.e. control situations); as a result, if the fund were too small, he also doesn’t believe it would have had the returns it has had to date.
Don’t Over-Diversify
Buffett is willing to invest up to 40% of the partnership’s capital in a single investment. While he would prefer that 50 investments exist of which he is extremely confident in generating excellent returns, he argues that the market just doesn’t work like that. In response to those who argue that investors should diversify, he agrees in principle qualitatively, but he has yet to see a convincing argument of just how many stocks constitute proper diversification and why.
Don’t Base Investment Decisions On Predictions For The General Market
When the market falls, Buffett gets calls from his investors suggesting he sell stocks until such time as the outlook becomes more clear. This idea sounds ludicrous to Buffett since he believes one cannot tell in which direction the market is going and therefore it makes no sense to sell undervalued businesses based on some observer’s guess. Buffett refers the reader to Ben Graham’s The Intelligent Investor for more discussion of this topic.
Short-Term Results Can Conflict With Long-Term Results
Buffett discusses a security in which his fund invested which shows his temperament is quite different from that of his partners/investors. Even though Buffett’s fund owned shares of this company, he hoped that the price of these securities would fall further. This would, of course, hurt short-term performance, but would allow him to purchase more shares at an even bigger discount. The shares ended up rising, which contributed significantly to results; but Buffett laments that had the price stayed lower, long-term results would have been much more pleasing.
Reporting Period Matters
Continuing on the theme of long-term investing, Buffett discusses the usefulness of more frequent reports (i.e. shorter reporting periods). Because some of his investments produce wild swings in price within short periods, shorter reporting periods would be more likely to capture these swings rather than the long-term trend. For this reason, Buffett calls frequent reporting “foolish and potentially misleading in a long-term oriented business.”
Enjoy What You Do
In one 1967 letter, Buffett actually reduces his annual return goals. Instead of buying and selling businesses purely for profit, he seeks other, more satisfying objectives, even if they are not as profitable. For example, Buffett would prefer to use partnership funds “where I liked the people and the nature of the business” even though “more money would be made buying a business at attractive prices, then reselling them.”
The Index Matters
Buffett has repeatedly compared his performance against that of the Dow. As described earlier, one of the reasons the Dow was chosen as a measuring stick is because it is widely known. Unfortunately, as a price-weighted index, the Dow can be skewed by a few abnormal results. These abnormalities caused the Dow to underperform most actively managed funds during this period. Even investment management firms, who almost regularly underperform the market, were beating the Dow handily.
Beware Of Speculation
As terrific market returns became the norm, investors increased their willingness to risk their capital. The markets started to heat up. Buffett warns that chain-letter type stock-promotion practices are snow-balling, and he worries about the long-term effects these will have on the markets. In the short-term, however, they have caused stock prices to rise, which has allowed Buffett to sell many of his positions and sit on a pile of cash.
Stick To Your Strengths
While many funds were returning upwards of 100% during this speculative period, Buffett did not change his style. His standards remained the same, despite relative results (compared to new firms) that were unspectacular. He did not switch to this “new way” of investing, which was a form of speculation.
You Can’t Time Your Returns
In the previous year, Buffett lamented that new ideas were hard to find and therefore he projected a future performance that could not match that of the past. However, 1968 had still turned out to be spectacular, yielding a portfolio gain of 58%! This was the result of the price performance of a security Buffett called “simple but sound” whose time had finally come. Buffett quips that “investment ideas, like women, are often more exciting than punctual”.
Stick With Logic
Buffett quotes a few market observers with views dissimilar to his. One argues that a basket of securities can no longer be maintained over a period of weeks, as they must be studied minute-to-minute. Buffett finds this type of “investing” fascinating to watch, but in another sense appalling. Buffett also quotes an observer who writes that security analysts over 40 “know too much that isn’t true”. Buffett refuses to change his investing philosophy, however. He writes that an over-the-hill, overweight ballplayer with poor eyesight can hit a home-run every once in a while, but that doesn’t mean you change your line-up because of it.
$Berkshire Hathaway(BRK.B)$ $Berkshire Hathaway(BRK.A)$ $S&P 500(.SPX)$ $NASDAQ(.IXIC)$
Follow me to learn more about analysis!!
Comments